Investors eye the ‘cliff’ as Obama gains in polls

As President Barack Obama widened his lead over Mitt Romney in polls this month, traders at hedge funds and investment firms began shooting emails to clients with a similar theme: It’s time to start preparing for an Obama victory.

What many in the market worry about isn’t that high earners may pay more in taxes if Obama wins. They worry that federal spending cuts and tax hikes scheduled for 2013 will kick in on Jan. 1 and start pulling the country into another recession. The higher taxes and lower spending would total $600 billion. They take effect automatically unless Congress and the White House reach a deal before then.

If he’s re-elected, Obama will still face a House of Representatives controlled by Republicans the rest of the year. And the new Congress that takes office in January may have a Republican House, too. Investors says that’s likely to set up a budget battle similar to August of last year, which ended with the country losing its top credit rating and panicked investors fleeing the stock market.

“If you have any kind of gridlock, you run the risk of inaction,” says Tom Simons, a market economist at the investment bank Jefferies. “This is a situation where inaction is the worst outcome.”

Obama and others like former President Bill Clinton have expressed the belief that House Republicans could be more cooperative once the election is over.

“They’ll be faced with determining whether we get a recession or not,” says Jeff Kleintop, chief market strategist at LPL Financial.

Most on Wall Street think Congress and Obama would eventually manage to at least postpone some of impending tax and spending changes before this year is out.

The Congressional Budget Office recently laid out the grim consequences of such an event — often compared to dropping off a “fiscal cliff.” Starting Jan. 1, tax cuts signed by President George W. Bush expire as do Obama’s cuts to payroll taxes. Federal spending on defense and other domestic programs will drop, while emergency unemployment benefits run out.

The combined effect off all these changes would shrink the economy nearly 3 percent at an annual rate in the first half of next year, the CBO estimates, and push unemployment up to 9.1 percent by the fall. The unemployment rate was 8.1 percent in August. Recent surveys of businesses suggest the threat is already weighing on the minds of executives when they’re making hiring and spending plans.

For the world’s biggest money managers, the fiscal cliff now ranks as the greatest hazard to the global economy, according to Bank of America’s most recent fund manager survey. It topped the European debt crisis, a collapse in Chinese real estate and even a war between Israel and Iran.

The danger looms so large to most investors that they believe Washington will find a way to escape it.

“Ultimately, I think a deal gets done, but it’s just a question of how long it takes to get there,” Kleintop says. “By no means is it going to be an easy process. Gridlock means there’s a greater chance that this drags on into next year.”

Analysts at investment firms have kept a close eye on polling numbers and especially on the Intrade, an online marketplace where members can trade predictions on events like elections. Polls show voters leaning toward Obama in key swing states. On Intrade, the odds have swung strongly in Obama’s direction, jumping to a 76 percent chance of re-election, up from 51 percent at the start of September.

Intrade markets put the chance that Republicans will retain control the House at 74 percent.

If these forecasts prove right, the balance of power in Washington would remain the same. Democrats keep the White House and a slim majority in the Senate, and Republicans keep the House.

What troubles investors is that the same elected officials who fought over raising the debt ceiling last year could be taking up the same task again while debating how best to maneuver around the fiscal cliff. Treasury officials have estimated that Congress won’t have to raise the debt limit until January.

Expect to see a replay of the debt-ceiling fight, says Ian Lyngen, a senior government bond strategist at CRT Capital. Except that this time what’s at stake is the country’s borrowing limit and a recession.

“I’m sure it’s going to go just like it did last time — very messy,” Lyngen says.